Liability under Securities Law

Baliga, Wayne, Journal of Accountancy

A U.S. district court ruled that an accounting firm was not liable under federal securities laws for misrepresentation in a company's financial statements. In 1993, Ernst & Young client Cygne Designs, a clothing manufacturer, announced the acquisition of another clothing manufacturer in exchange for Cygne stock. It publicly represented that this acquisition would increase its earnings and profitability. The goodwill from the acquisition, which closed in April 1994, was booked at approximately $47 million.

Notwithstanding Cygne's favorable public representations regarding the acquisition, the plaintiffs--Cygne investors--claimed that Cygne and the firm had learned during a due diligence review (before the acquisition) that the purchased company was experiencing problems, so there was no reasonable basis to believe the purchase price or the booked goodwill could be recovered. The plaintiffs asserted section 10(b) and rule 10b-5 (of the Securities Exchange Act of 1934) claims against the firm based on Cygne's 1993 and 1994 financial statements. The plaintiff; said that the firm had fraudulently issued "clean" audit opinions on the statements despite its knowledge of facts that revealed the falsity of the statements.

In response to the complaint, the firm filed a motion to dismiss pursuant to rules 12(b)(6) and 9(b) of the 1934 Act. In support of its rule 12(b)(6) motion, the firm successfully asserted that the general allegations of GAAP and GAAS violations failed to satisfy the scienter requirements of section 10 (b) and rule 10b-5. (The scienter requirements can be satisfied by demonstrating specific facts: (1) showing a motive for committing fraud and clear opportunity for doing so and (2) indicating conscious or reckless behavior by the defendants.) District Court Judge Kram agreed with the holding in SEC v. Price Waterhouse (797 F. Supp. 1217 [S.D.N.Y. 1992]) that the mere misapplication of accounting principles by an independent auditor does not establish scienter. A plaintiff must prove that the accounting practices were so deficient that the audit amounted to "no audit at all" or that the accountant's judgments were such that no reasonable accountant would have made the same decisions if confronted with the same facts. In judge Kram's opinion, for the plaintiffs' claims of purported GAAP and GAAS violations to be actionable, the plaintiffs would have had to allege that the firm's alleged violations were the result of intentional deceit or that they rose to the level of recklessness.

The judge said the complaint also failed to comply with the pleading requirements of rule 9(b). In his opinion, a plaintiff can satisfy the Second Circuit's standard for alleging facts (see SEC v. …

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